This Rule Change Could Crush Ethanol Demand

When it comes to the domestic ethanol industry, there are two keys to profitability. One is demand, which is determined by just how much of this alternative corn-based fuel is being mixed with the nation's gasoline supply. The other is the so-called "crush spread," which is the difference between the value of ethanol that can be extracted from a bushel of corn and the cost of that bushel.

While these yardsticks have been generally positive for much of the year, a recent proposal by the Environmental Protection Agency could have a major negative impact on both measures and the companies that depend on them.

If approved, shares of leading ethanol pure-plays like Green Plains Renewable Energy , Pacific Ethanol,and REX American Resources could be in for a significant hit. Additionally, a few conglomerates that have increasingly focused on ethanol to boost their overall performance -- notably Archer Daniels Midland and Valero Energy -- could also see their profitability tumble.

Let's take a look at the proposed rule change, where these producers stand right now, and how the former might impact the latter.

Demand and the government's proposalIn mid-November, the EPA announced that it was considering a reduction in the amount of ethanol it requires in the gasoline supply. It said most auto fuel systems and service stations are not designed to handle more than a 10% mix, called E10, and the public has not been clamoring for more.

Many vehicles on the road today can actually use blends up to E85, but very few owners are interested and only a tiny fraction of service stations offer it. A compromise push to allow the sale of E15 blends has similarly gained virtually no traction.

Compounding the issue, oil imports have declined and domestic production has mushroomed. At the same time, drivers have cut back on their driving and are using less fuel. This combination has led officials to reconsider the gradually escalating ethanol usage levels called for in the Renewable Fuels Standard, or RFS, that Congress created in 2005 and expanded in 2007 to help decrease America's dependence on foreign supplies.

One unintended result of all this is that the increasing mandates have caused ethanol to grow to an unintentionally large percentage of the total fuel supply. This has pushed it closer to the so-called "blend wall," which is the point where fuel marketers must move to higher-percentage ethanol blends than the public, and suppliers have shown their support. Calls for changes, particularly from the big oil companies, ultimately led to the recent proposal.

The EPA is now in the midst of a 60-day public comment period and a decision should be finalized by early next year. Ethanol producers and other proponents who don't want the mandates reduced are justifiably worried that it will not go their way.

Crush and its impact on producersAll this comes at a time when the beleaguered ethanol industry finally began to see a marked upturn in its fortunes, which I chronicled last May. While Pacific Ethanol has continued to struggle compared to its peers for a variety of unique reasons, the positive momentum has continued and shares in these companies have shown excellent year-to-date results: Green Plains is up 80%, REX is up nearly 60%, ADM is up more than 50%, and Valero is up 25%.

The reason, largely, has been the crush spread. Ethanol margins had become negative in 2012, when the severe Midwest drought pushed corn prices sky-high just as gasoline prices were stabilizing. But from the start of 2013, expectations of an adequate corn supply reversed all that. And analysts said the crush spread improvement helped Green Plains, for one example, report a 47% year-over-year boost in third-quarter gross profit despite a 20% drop in revenue.

And Green Plains was hardly alone. REX's most recent earnings came in 15% above analyst estimates, the company's second consecutive strong quarter attributed to the crush spread's recovery from 2012 lows. ADM's third-quarter earnings more than doubled year over year, partly on increased profit margins on ethanol.

Valero officials said higher gross margins (and higher production volumes) were primarily responsible for the company's ethanol segment reporting a $186 million increase in operating income during the period. And even laggard Pacific Ethanol saw gross profit rise during the most recent quarter to $3.5 million from a gross loss of $2.4 million a year ago.

But just as the EPA was proposing a reduction in the ethanol mandate beginning as soon as next year, ethanol's price relative to gasoline -- and, with it, the crush spread -- started to collapse. Many observers believe the EPA's proposed changes would push this down even more dramatically because it would result in unprecedented overproduction of the fuel. Profits would accordingly suffer badly.

The Foolish bottom lineUnder the EPA's proposed changes, the mandated use of ethanol next year would be 16% less than the government currently requires. This and similar future declines that would be driven by continually falling gasoline consumption have shaken analysts, and rightly so. The related beginnings of a deteriorating crush spread are already being seen, and will only get worse if a drop in demand leads to overproduction and drives ethanol prices lower.

The industry can partially counter this by idling some of its plants, an action it has taken in the past. Corn and gasoline prices remain the wildcards, though. Keeping an eye on these three things -- as well as the EPA's proposed rule changes -- could help Foolish investors plot a sensible course as the ethanol industry tries to weather yet another storm.

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